Will Dividend Cuts Run Amok In Telecoms?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With recent news of CenturyLink’s (NYSE: CTL) big dividend cut, questions arise about the other major land-line telecom companies, Windstream (NASDAQ: WIN) and Frontier Communications (NASDAQ: FTR), and whether dividend cuts for these companies are to come. The fundamental issue for these cuts and an expected earnings decline for all of these companies is their deteriorating business models, with all three telecoms already missing earnings estimates for their December-ended quarter.

CenturyLink’s last quarter earnings indicated that the telecom company plans to cut its dividend by 25%. CenturyLink's decision to cut its dividend was done in an effort to better redirect cash flow, but the stock was punished and tumbled over 20%. For the same period, CenturyLink's major peers, Windstream and Frontier, also saw big selloffs... 

<img src="http://media.ycharts.com/charts/656c7b02611f42a50df8e92075628dd3.png" />

Digging deeper into CenturyLink's earnings (check out CenturyLink's profile), the company posted EPS of $0.67, missing analysts’ estimates by a penny. The telecom also revised 2013 EPS estimates to $2.50 - $2.70, coming in at the low end of analysts’ estimates of $2.64. As far as cash flow generation, the company expects to generate $3 billion to $3.2 billion of free cash flow in 2013, down from the $3.33 billion in 2012. The free cash flow generating capabilities keep investors invested in the stock as it's what pays the dividend, so if the dividend goes, so goes investors.  

As a quick overview, Windstream (see how hedge funds are trading Windstream) has the highest dividend yield, but Frontier has been the major telecom that has been steadily reducing its dividend over the past five years...

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Frontier</strong></p> </td> <td> <p><strong>Windstream</strong></p> </td> <td> <p><strong>CenturyLink</strong></p> </td> </tr> <tr> <td> <p><strong>Annual Dividend</strong></p> </td> <td> <p> $0.40</p> </td> <td> <p> $1.00</p> </td> <td> <p> $2.90</p> </td> </tr> <tr> <td> <p><strong>Dividend Yield </strong></p> </td> <td> <p>9.77%</p> </td> <td> <p>11.20%</p> </td> <td> <p>7.25%</p> </td> </tr> <tr> <td> <p><strong>5-Yr. Historical Dividend Growth</strong></p> </td> <td> <p>-18.70%</p> </td> <td> <p>0.00%</p> </td> <td> <p>30.10%</p> </td> </tr> </tbody> </table>

Frontier's foresight to cut its dividend will likely not save the company from having to cut its dividend yet again in the near future, but it may well prevent the company from having to make as a significant cut as Windstream. 

So, should Windstream and Frontier investors be afraid of a dividend cut? Based on a free cash flow basis, CenturyLink, with its new dividend payment of $0.54 per share, has a dividend payout on a cash flow basis of around 40% (55% payout prior to dividend cut) . How do the others stack up?

  • Windstream, well in excess of 100% of FCF
  • Frontier, 40% of FCF 

Based on this, it appears Windstream is to face some of the worst pressure to cut its dividend. It also appears that Windstream is also under the most pressure on an earnings payout basis too. Assuming no dividend growth, this is how the pro forma dividend payout ratios stack up based on Wall Street’s earnings estimates:

<table> <tbody> <tr> <td> <p><strong>CENTURYLINK</strong></p> </td> <td> <p><strong>2011</strong></p> </td> <td> <p><strong>2012</strong></p> </td> <td> <p><strong>2013E</strong></p> </td> <td> <p><strong>2014E</strong></p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p> $2.36</p> </td> <td> <p> $2.67</p> </td> <td> <p> $2.55</p> </td> <td> <p> $2.70</p> </td> </tr> <tr> <td> <p>Dividend Per Share</p> </td> <td> <p> $2.90</p> </td> <td> <p> $2.16</p> </td> <td> <p> $2.16</p> </td> <td> <p> $2.16</p> </td> </tr> <tr> <td> <p>Payout Ratio</p> </td> <td> <p>123%</p> </td> <td> <p>81%</p> </td> <td> <p>85%</p> </td> <td> <p>80%</p> </td> </tr> </tbody> </table>
<table> <tbody> <tr> <td> <p><strong>FRONTIER</strong></p> </td> <td> <p><strong>2011</strong></p> </td> <td> <p><strong>2012</strong></p> </td> <td> <p><strong>2013E</strong></p> </td> <td> <p><strong>2014E</strong></p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p> $0.24</p> </td> <td> <p> $0.27</p> </td> <td> <p> $0.26</p> </td> <td> <p> $0.21</p> </td> </tr> <tr> <td> <p>Dividend Per Share</p> </td> <td> <p>n/a</p> </td> <td> <p> $0.40</p> </td> <td> <p> $0.40</p> </td> <td> <p> $0.40</p> </td> </tr> <tr> <td> <p>Payout Ratio</p> </td> <td> <p>n/a</p> </td> <td> <p>148%</p> </td> <td> <p>154%</p> </td> <td> <p>190%</p> </td> </tr> </tbody> </table>
<table> <tbody> <tr> <td> <p><strong>WINDSTREAM</strong></p> </td> <td> <p><strong>2011</strong></p> </td> <td> <p><strong>2012</strong></p> </td> <td> <p><strong>2013E</strong></p> </td> <td> <p><strong>2014E</strong></p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p> $0.71</p> </td> <td> <p> $0.50</p> </td> <td> <p> $0.56</p> </td> <td> <p> $0.58</p> </td> </tr> <tr> <td> <p>Dividend Per Share</p> </td> <td> <p> $1.00</p> </td> <td> <p> $1.00</p> </td> <td> <p> $1.00</p> </td> <td> <p> $1.00</p> </td> </tr> <tr> <td> <p>Payout Ratio</p> </td> <td> <p>141%</p> </td> <td> <p>200%</p> </td> <td> <p>179%</p> </td> <td> <p>172%</p> </td> </tr> </tbody> </table>

An industry in despair. The competition for landline telecommunications companies is robust, with notable competition coming from cable TV operators that are offering traditional voice via their networks. Other pressure is coming from mobile carriers, namely AT&T and Verizon, which have put pressure on all the companies' access lines, and led to industry pricing pressure. This pressure should only continue as wireless carriers expand their network, leading to more consumers migrating to a wireless only service and ceasing to use traditional wireline phone services. 

Notable future pressure for CenturyLink will come from its decline in subsidy payments received under the Federal Universal Service Fund or USF, which provides funding for lower income consumer coverage. The USF plans to reduce access and compensation rates charged by CenturyLink over the next six years. CenturyLink is also working on finishing the integration of Qwest, which will increase operating costs going forward. The company expects integration to cost between $650 million and $800 million over two to four years. 

For Frontier, About 65% of its access lines are exposed to cable voice service offerings, where the likes of Time Warner Cable's Voice over Internet Protocol (VoIP) has the ability to infringe upon Frontier's addressable market. Frontier also continues to experience decline in regulatory derived revenue due to lower subsidy payments received under federal programs. Compensation rates charged by Frontier is expected to decline over the next six years as well, as federal programs tighten spending for telecom services (check out Frontier's profile).

Both Windstream and Frontier are currently being strained by high debt loads thanks to previous acquisitions. These debt levels will put a strain on future cash flow and hinder the companies' ability to adjust to its changing industry.  

Debt to Capital

  • CenturyLink 50%
  • Frontier 68%
  • Windstream 75%

All of these stocks also trade relatively in line with respect to valuation, which I feel should not be the case. CenturyLink is the stronger of the companies on a dividend and balance sheet basis, but trades the cheapest. Windstream, with its 75% debt to capital, 200% dividend earnings payout and 100%+ dividend free cash flow payout, trades the richest. I think the case could be made that Windstream is a short candidate.

Price to Earnings

  • CenturyLink 28x
  • Frontier 29x
  • Windstream 30x

Don't be fooled. The rich dividend yields being offered by these telecoms are enticing, but the fundamental issues with their business models still exist, which is expected to continue to hamper earnings potential. This in turn brings up concerns about the dividend payments. CenturyLink has taken the lead, despite the fact that it was already one of the bet positioned stocks on a cash flow and payout basis, which indeed suggest there could be more dividends cuts to come by the other major telecom operators. 


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